Overview
- The market continues to misprice the strength of the US consumer due to the misleading nature of the unemployment rate, which fails to capture those that have left the labor force. We can see this by backing into the current unemployment rate given average weekly earnings and discretionary consumption, as it indicates the real rate is closer to 6-7% versus the quoted rate of 4.3% today. That said, we see participants changing their optimistic views in the back half of the year, as the breadth of the labor market is indicating non-farm payrolls will turn negative in the next 6-8 months. (p.9)
- The focus on falling unemployment has overshadowed the rising signs of consumer stress that have historically preceded consumption downturns. Based on our leading indicators below, we should see credit card and auto delinquencies continue to rise over the next year. This will adversely affect consumption, as credit expansion has been one of the primary drivers of retail sales and the key funding source of rising core expenses [shelter, health care, financial services]. (p.13-16)
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- There is evidence that the recent industrial and commodity rebound was a result of China’s large scale stimulus efforts from June 2015 – June 2016 [~$4.3T in credit creation]. This led to a rally in commodities, which in turn drove the US industrial economy higher, along with the ISM. (p. 21-23) Given that China’s credit creation leads the economic data by 7-8 months, we should see a swift move lower in commodities and the ISM into years end.
- Technically, we are beginning to see signs of weakness, as the percentage of stocks below their 50 and 200 day moving averages have diverged from price near all-time highs. (p. 31-32)This is at a time when excess liquidity - or the dollars freely able to move into markets - has turned lower and participants are positioned aggressively long. In addition, we have also seen multiple upside Demark exhaustions across the broader indices, as well as the top 10 performance constituents of the S&P, indicating the probabilities favor a move to the downside.
- Given the thesis outlined below, there are four trades that are actionable today:
- Deutsche Bank - The S&P 500 Could Be About To Roar Higher
1) Sell S&Ps [S&P 500]
2) Buy TLT [Barclays 20+ Year Treasury Bond]
3) Sell XRT [ S&P Retail ETF]
4) Sell DBB [Powershares Base Metals ETF]
The True Rate of Unemployment
The unemployment rate, while a lagging indicator, has historically provided a reliable read on the state of the US economy. Today, the rate stands at 4.4%, a level that is consistent with a tight labor market and wage growth. At face value, this thesis seems to be true, but digging deeper it is apparent it is flawed.
This point can be illustrated by the historical relationship between the employment-to-population ratio and the unemployment rate, shown below. Since 1976, the two have been strongly correlated, however this broke in 2011. The divergence can primarily be attributed to those that have left the labor force, as these individuals are no longer counted in the unemployment rate, which in turn drives the dark blue line lower, while those employed remains constant.
The street has attributed the deviation to retiring baby boomers, and while not entirely false, the chart below provides an alternative view –that is, a material portion of those that have left the labor force are part of the working age population (25-54), while those over 55 (baby boomers) are unchanged.
We can see this below by the percentage of 25-34 year olds living with their parents, which increased materially since 2008.
This was recently confirmed in a report from the US Census Bureau finding that 25% of the millennial population (2.2mm) are neither enrolled in school nor working. Given the material trend higher in core living expenses, it is also very likely that a large portion of the 25-34 year old's [that are working] are living at home due to cash flow deficits.
If we assume that the street is correct in that the divergence is solely due to the baby boomers leaving the work force, we must then bring down forward growth estimates, as a retiree spends 25% less than a working individual according to Wells Fargo, shown below.
The Misconception of Average Hourly Earnings
The lack of wage growth is not apparent by looking at the headline average hourly earnings (AHE) rate, as it is currently moving from the lower left to the upper right, as shown the far right chart below.
And while the assertion that the chart is moving higher is correct, the premise that it is due to tightness in the labor market is false due to a misinterpretation of AHE, which is not a payment for a given unit of work or time, but a derived ratio from two separate BLS surveys.
The survey is based on two principal inputs:
1) Average weekly earnings – which is the aggregate amount of total weekly payments from an employer to its employees; and
2) Average weekly hours – the total amount of hours that employers are reporting employees are working
From this calculation, the most relevant number is aggregate pay, shown below in the bottom left chart, as it is the total amount of income to consumers.
Hours are relevant in the sense that it gives an indication of labor demand, but when used together, it materially distorts the picture.
For example, holding aggregate pay (AWE) constant, declining hours result in rising AHE, but employees are not making more, as it is not a payment for a given unit of time or work, but a derived ratio.
This is what we are seeing today as average weekly earnings growth has been flat, while hours recently have declined, leading to growth in average hourly earnings.
This point can be illustrated by the negative correlation between average hourly earnings (-40%) and retail sales ex autos and gas, shown below. This is to say that as consumers make more per hour, they consume less.
Referring to the primary driver –average weekly earnings –we find there is a 48% positive correlation to retail sales, shown below.
Article by Teddy Vallee
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